Random Walk Trading – Professional Synthetic Relationships
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An important principle in options pricing is called a put-call parity. It says that the value of a call option, at one strike price, implies a certain fair value for the corresponding put, and vice versa. The argument, for this pricing relationship, relies on the arbitrage opportunity that results if there is divergence between the value of calls and puts with the same strike price and expiration date. Arbitrageurs would step in to make profitable, risk-free trades until the departure from put-call parity is eliminated. Knowing how these trades work can give you a better feel for how put options, call options and the underlying are all interrelated.
The Synthetic Position
Option-arbitrage strategies involve what are called synthetic positions. All of the basic positions in an underlying stock, or its options, have a synthetic equivalent. What this means is that the risk profile (the possible profit or loss), of any position, can be exactly duplicated with other, but, more complex strategies. The rule for creating synthetics is that the strike price and expiration date, of the calls and puts, must be identical.
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